Case Study: Law of Business Entities

Question One

The main issues addressed in this question are the following: was the issue of shares by AAC directly to GE in return for money a violation of United Steel Ltd’s rights; does AAC has to adhere to the contract conditions, if this contract was signed by its former official, at the time when he was already fired by the corporation? The issues will be resolved by means of utilizing different concepts and clauses from the Australian legislation that ahs direct effects on the big corporations, like the ones described in the question.

The first issue is associated with the laws regulating preemptive rights for shares of the existing shareholders (United Steel Ltd). We shall not say that shareholders do not have any “positive” control rights over the corporation granting them direct input into and say over how the corporation is governed or whether certain business opportunities are pursued. Shareholders have the right to vote for the board of directors, most importantly, and can make recommendations on governance and business matters to the board through the shareholder proposal process. (Baxt, Robert, 2006)

Shareholders (United Steel Ltd) also have the right to vote on certain mergers and on any proposed sale of all or substantially all of the corporation’s assets (which is definitely the case here, as AAC and GE are contemplating merger, and try to neglect the company that has 40 % of shares of AAC. In addition, a company’s articles of incorporation cannot be amended without shareholder approval, and shareholders can vote to amend the bylaws. (Lipton & Herzberg, 2006) Shareholders, however, do not have any authority to manage the day-to-day business directly or to set overall corporate policy and strategy, unless granted such control in the certificate of incorporation, which happens rarely, if ever.

Directors have the right to take defensive steps to fend off a hostile bidder, which effectively blocks shareholders from selling their shares, even though the bidder might have offered a significant premium for the company. (Lipton & Herzberg, 2006) In most instances, the board, and not shareholders, also gets to decide whether to bring a derivative suit against directors and officers who allegedly breached their fiduciary duties.

For the most part, management controls the shareholder voting process and sets the voting agenda, which heavily influences results. Few shareholders, other than institutional investors, own enough stock to make it worthwhile to monitor the company actively. Likewise, the cost of complying with the extensive disclosure requirements of the proxy rules as well as the risk of liability for failing to comply can chill shareholder communication and deter shareholders from waging proxy contests, which can cost millions of dollars. In other words, coordination difficulties and rational apathy frustrate shareholder efforts to exercise their franchise (which is certainly not the case with United Steel Ltd).

As for the second issue involved in this question, the concepts of ‘promissory estoppel’ and ‘mutuality of obligation’ may be deployed in order to resolve the case with the contract signed by Tony on behalf of AAC. Promissory estoppel allows enforcement of a few stray promises after the plaintiff has performed or changed position. Stated otherwise, courts often suspend the requirement of “mutuality”: no longer is the promisor free because the promisee was not bound. (Baxt, Robert, 2006)

Even though mutuality often captures commercial intentions in a world of self-interested behavior, it is only a first approximation, not a sine qua non for rational behavior. Often hopes for indirect benefit and the creation of good generate a desire to create free options in other individuals. A firm offer left open for a definite period of time is one such example. The nature of the interaction generates a level of protection for both sides. The offeror can limit the time that the offer remains open (or the time that goods will be kept “on hold” for a particular customer). (Lipton & Herzberg, 2006)

Even so, he runs some risk that offer will be rejected, while another sale was foreclosed. So a merchant or trader is likely to make a firm offer only to someone likely to consider it seriously. The additional legal risk yields an increased probability of acceptance. On the other side, an offeree who takes up idle offers spends resources that yield no return.

(Lipton & Herzberg, 2006) So firm offers are not costless to those who receive them. The process is thus bounded by powerful institutional constraints, so why preclude anyone from making that offer binding unless he receives consideration in exchange?

All in all, this expansion of liability should be regarded as compatible with the doctrines of freedom of contract, not as its enemy. The parties who do not want to be parties to unilateral arrangements do not have to make them. Taking into consideration the regulations and clauses cited, and also taking into the fact that Tony was already fired when signing the contract with CMI, AAC should not be obliged to adhere to the terms of contract signed by Tony.

Question Two

The major issue that arises out of the circumstances of this particular case is Tom Lam’s responsibility for using his position in the UAT corporation for his own interests (even after he retired from the Company’s Board of directors), and the concept of misappropriation doctrine. Tom’s sale of company’s shares upon receiving internal information about the events that would decrease share value substantially may be classified as somewhat peculiar ‘insider trading’, in which Tom. Being aware of the information not available to other market participants, makes profit where he could actually ended up having tremendous losses.
We first need to consider the fact that Tom was an employee of UAT corporation. Employees are obviously in a fiduciary relationship with their employers. Most of the violations under the misappropriation doctrine are convicted for using information belonging to their employers. (Baxt, Robert, 2006) Employees who work under an employment contract that forbids such trading and who nonetheless trade do so in clear violation of the misappropriation doctrine. It is just as clear that employees who are given express permission by their employer to use nonpublic information to trade in stock substitutes are not guilty of misappropriating information from their employer. Many employees, however, work under contracts that are silent on this issue (and Tom, as a matter of fact, could have such contract as well). Can such employees trade?

Analytically, it might be useful to imagine two distinct default rules that might govern employee trading rights. Under what we refer to as a fiduciary-sourced default, an employee could not use material nonpublic information obtained through her employment to trade on stock substitutes unless she had the permission of her employer. Under what legislation refers to as a possible harm standard, Tom would be prohibited (absent permission) from “only those trades that posed a real possibility of harm to his employer.” (Baxt, Robert, 2006)

The “possible/probable harm” standard resonates as a “hypothetical” or “majoritarian” default –in that it seems to be the type of rule that most parties would contract for if expressly called upon to do so–while the “fiduciary-sourced” standard resonates more as an “information forcing” or “penalty” default which forces employees to expressly contract ex ante for the right to trade or ex post to seek permission with regard to particular trades. (Baxt, Robert, 2006) Of course, it may be that a majority of parties actually prefer this kind of information forcing–so that employers can more directly negotiate share(s) in the benefits of information that flows to agents from the fiduciary relationship. The case law in this area is ambiguous. (Lipton & Herzberg, 2006)

The misappropriation doctrine has been successfully invoked by the Australian government even in cases in which there were no contractual or express limitations on trading. The government has successfully brought prosecutions under the doctrine in familial settings, where the limitations on trading are necessarily implicit. In the employment context, virtually all of the cases over implicit limitations involve an employee purchasing stock of a “target” company. (Lipton & Herzberg, 2006) The target company has been either a company the trader’s employer was about to acquire, a company that a client of the trader’s employer was about to acquire, or a company in which the trader’s employer was about to make a substantial equity contribution. (Lipton & Herzberg, 2006)

The target cases are of course consistent with a fiduciary-sourced default, which requires an employer’s permission before using employment-related material nonpublic information for stock substitutes trading. The target cases are also consistent with a possible harm theory. An employee who purchases a target stock may be seen by the government or court to be acting against the interest of her employer. If the employer is the acquirer, the purchase may drive the stock price up, or tip off others of an impending acquisition. (Baxt, Robert, 2006)

If the employee works for a law or accounting firm, and the stock is of a target of a client of that firm, the purchase may tarnish the employer’s reputation with the client, either because it hurts the client directly through increased stock price of the target, or because it destroys the law or accounting firm’s reputation for confidentiality. Indeed, the target cases can even be explained not in terms of misappropriation at all, but instead as straightforward applications of the temporary insider doctrine. (Lipton & Herzberg, 2006) A lawyer working for a law firm representing either the acquiring or target company is in at least indirect privity with the target company, and hence might be deemed a temporary insider who cannot trade the target stock.

By the same analogy, Tom was not supposed to use the information provided to him as an UAT employee for his own advantage (both selling UAT shares once obtaining information about upcoming price decrease and using offer about the new project, that was initially made to the Company’s Board of Directors, not to him as a private entrepreneur). By doing this, he has violated corporate regulations, and would have been punished accordingly by the Australian laws, when his actions would have been uncovered.

Question Three

Based on the situation described in the case, De Beers Ltd is in quite bad situation because of its managing director, Sam Kruger. It is apparent that Sam, on behalf of his company, had misled numerous people and provided them with false information about the situation that would occur after company’s share issue. It is also obvious that this was done intentionally, with the purpose of attracting more capital to the company, that was needed so drastically for its further expansion. Another important issue to be addressed here is the inefficacy of the Company’s Board of Directors, that is not capable of controlling Sam’s actions and defending shareholders needs.

If directors don’t really understand what is happening at the company or if its board lacks the time to tackle an issue, management ought to identify the board’s role in critical management processes such as budgeting, the making of strategy, and the evaluation of managers. Board and committee meetings should be restructured to ensure that directors have the time to discuss critical issues. Sessions when management isn’t present should be common at the end of board and committee meetings. (Baxt, Robert, 2006)

When directors complain about receiving too much information too late or too inconsistently, that is a sure sign the board’s information processes should be overhauled, starting with direct reporting lines to corporate secretaries. Key managers should report regularly to committees, answer the questions of their members, and educate them on specific situations and areas they wish to investigate. Boards should have discretionary budgets to obtain outside advice on issues such as management compensation and major financial transactions. “Directors can master this arm’s-length guiding role by developing a better understanding of the industry, by playing a part in shaping strategy, and by monitoring its execution.” (Lipton & Herzberg, 2006)

Stronger relationships encourage good managers to seek out the views of directors about strategic initiatives early on and to maintain contact throughout the strategy-setting process. Directors should always be able to counter with alternative strategic options and to scan competitive threats. Such discussions could be held at regular board meetings, but it is better for the board and for managers to devote a number of days to strategy–preferably away from the office—in order to delve into specific topics, plan strategies, and build a consensus. To improve the implementation of strategy, boards and managers should agree about long-term indicators such as market share, capital productivity; and profit margins. (Lipton & Herzberg, 2006)

Ensuring that the performance of a business matches the expectations of its shareholders is a board’s most important ongoing function–and one that requires accurate, independently assessed financial information. Investors clearly doubt the integrity of the financials of many companies, and regulators have turned to institutional remedies: CEOs in the United States, for instance, will have to certify the financials of their companies every year.

To rebuild a reputation for integrity, every board will thus have to start by ordering a comprehensive review of the accounting practices of the company and by testing its major assumptions about revenue, capital, off-balance-sheet items, and other key data, as well as any variances from generally accepted sector or market practices. (Baxt, Robert, 2006) Boards should highlight major inconsistencies in the data and resist the temptation to step back from contentious areas.

What is more, in the light of the past year’s scandals, why would a board want to use external auditors to provide any service besides auditing? If they must do so, companies should at least show why this practice makes good business sense and be prepared to demonstrate that no conflict of interest will result. Further, the audit committee, not management, should select and appraise the external auditors annually. Companies ought to adopt clear rules about hiring an external auditor’s employees–for example, rules limiting the number of such appointments and implementing processes to maintain the integrity of the internal audit. (Lipton & Herzberg, 2006) The company should also have a rule requiring it to rotate the audit partner regularly, perhaps every five years.

With sound financials in place, the board can review key performance indicators to make sure that they line up with the overall objectives of the company and its investors. Management may need to educate directors about the significance of these indicators, such as budgets and quarterly earnings, for the strategic aims of the company and for investors. (Baxt, Robert, 2006) Ongoing corporate-level performance evaluations should aim to spot and investigate any failure to meet targets. When such failures occur, management should discuss corrective actions with the board.

In the case presented, it is apparent that Sam was able to manipulate both the Board’s members and potential shareholders. For his actions, he should be made liable in full according to the respective Australian legislation. Moreover, the company at large will have to share some of the liabilities, with Sam. As it would be almost impossible to separate Sam from the company for the legal purposes.

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